The Next Crash

Is the housing market a bubble that’s about to burst?

On July 8, 1949, the Long Island Star Journal published a full-page ad for a community of affordable homes that the developer Levitt & Sons was building on a tract of farmland near Farmingdale, about twenty miles east of Queens. The ad featured an eight-hundred-square-foot ranch house on a sixty-by-one-hundred-foot plot. “This is Levittown! All yours for $58!” a month, the ad read. “Practically everything you can think of is included in that price. Refrigerator, range, Bendix, Venetian blinds, General Electric oil burner, legal fees, appraisal charges—yes, sir, the whole works are in.” Prospective buyers could choose from five slightly different models, which were all priced at $7,990. If they were former G.I.s, as most were, the government guaranteed them a mortgage, with no down payment.

As recently as the summer of 2000, there were houses for sale in Levittown for under two hundred thousand dollars. After the Nasdaq crash of April, 2000, prices fell for several months in a row, and Richard Dallow, the owner of the Dallow Agency, one of Levittown’s leading real-estate agents, thought that the long-predicted property slump had arrived. He had to reduce the price of one house from $199,000 to $189,000, and then to $179,999. It finally sold for $177,000. But in the fall of 2000 buyers returned to the market. To Dallow’s surprise, prices kept rising right through the recession that began in March of last year, through the aftermath of 9/11, and through the first nine months of this year. “If we could buy that house for two hundred thousand dollars today, we’d grab it in an instant,” he said. “Today, that same house would probably be in the two-hundred-and-seventy-five-thousand-dollar-to-three-hundred-thousand-dollar range, and it would go quickly.”

Richard Dallow’s family has been selling real estate in Levittown since 1951, when his father, Ted, moved there from Queens. Dallow has lived through several real-estate booms since joining the family business, in 1971, but the endurance of this one has stunned him. During the 1990-91 recession, house prices in Levittown fell by about a fifth, and they remained steady for several years. Dallow expected the current recession to cause a similar downward adjustment, but instead houses keep getting more expensive. “It has to impact at some point,” he said. “But, then again, in the summer of 2000 I thought it was impacting, and then things came back.”

By and large, the kinds of people buying houses in Levittown are the same as they have always been: cops, firefighters, janitors, retail workers, and others to whom fifty thousand dollars a year is a good salary. But now many of them have to apply for jumbo mortgages—loans of more than three hundred thousand dollars—which used to be reserved for the well-to-do. “Levittown has always been a low down-payment area,” Dallow explained. “If the price is three hundred and thirty thousand and you put down five per cent, that’s a mortgage of three hundred and thirteen thousand five hundred. You need a jumbo mortgage. For Levittown.”

A few years ago, it became fashionable to deny what was, in retrospect, perfectly obvious: a speculative bubble had developed on Wall Street. Instead of warning investors to go easy, bullish analysts came up with increasingly outlandish justifications for stratospheric stock prices: the death of inflation; the rise of the Internet; a productivity “miracle”; the end of the business cycle; the aging of the baby boomers. Such rationalizations aren’t heard much in connection with the stock market these days, but similar arguments are becoming prevalent in discussions of real estate. “The single-family housing market is not in a bubble, and I don’t think it is susceptible to a bubble,” said Frank Nothaft, the chief economist at Freddie Mac, one of two government-sponsored companies—the other is Fannie Mae—that provide mortgage financing to tens of millions of American families. “The economic fundamentals help to explain a lot of what we have seen with house prices in recent years.” Nothaft ran through a list of these fundamentals: the mildness of the recession; low mortgage rates; the modest inventory of new homes; rising demand for housing from immigrants and “echo boomers”—boomers’ children who are old enough to start families and buy a home. “We are not going to see the price of single-family homes fall,” he insisted. “It ain’t going to happen.”

Many independent economists are also sanguine. Karl Case, a Wellesley economics professor who specializes in the real-estate market, reminded me that the average price of houses across the country has risen every single year since the Second World War. Alan Greenspan, the chairman of the Federal Reserve Board, has also dismissed comparisons between the real-estate market and the stock market. Speaking on Capitol Hill in July, he said that house prices reflected rising immigration and a shortage of building land. Of course, Greenspan has a vested interest in keeping the housing market humming. For the past eighteen months or so, he has been relying on the stimulative effects of the housing boom to offset a precipitate fall in business investment. If he succeeds in exploiting the buoyant housing market to prevent a “double dip” recession, it will be one of the great Houdini acts of economic policymaking.

Considering the way that Greenspan helped inflate the stock market during the late nineteen-nineties, by keeping interest rates artificially low and refusing to acknowledge the bubble, some homeowners might be tempted to put their properties on the market while they still can. In Levittown and elsewhere, many of them are doing just that. “They are saying we are never going to see prices like this again, and it’s time to sell,” Richard Dallow said. In Manhattan, where the average price of a two-bedroom apartment is now nine hundred and thirty-three thousand dollars, the number of properties for sale has risen sharply in the past couple of months, but would-be sellers may have missed the peak. In March, April, and May, the Corcoran Group, one of the city’s largest real-estate agencies, enjoyed the best three months in its history. Since then, the volume of sales has fallen short of expectations, and prices have started to slip. “Anecdotally, I can say that certain apartments are not getting the prices that they did in the spring,” Pamela Liebman, the president and C.E.O. of the Corcoran Group, confirmed.

The market is softening in other affluent areas as well, including parts of San Jose and the Dallas suburbs. This may be what Wall Street analysts used to call a “healthy correction,” which doesn’t spread to places like Levittown, but it could also mark the beginning of something much more serious. “In a real-estate crash, the top end of the market usually cracks first,” Christopher Wood, a financial analyst at C.L.S.A. Emerging Markets, a brokerage and investment bank, warned. “Then the bad news cascades down.” In 1989, at the peak of the last real-estate boom, Wood advised his New York friends to sell their apartments and rent for a year. He is issuing the same advice again. “The American housing market is the last big bubble,” he said. “When it bursts, it will be very ugly. In places like Manhattan and San Francisco, prices could easily drop forty or fifty per cent.”

Even Nothaft concedes that prices can’t keep on rising vertiginously. Over the next few years, he predicts, they will gradually revert to their historic rates of increase: between four and five per cent per annum. The many Americans who view their houses as their most important and enduring store of wealth will be hoping fervently that Nothaft is right. However, his optimistic prognosis inevitably brings to mind the declamations of stock-market analysts like Abby Joseph Cohen and James K. Glassman. While the Dow and the Nasdaq were on the ascent, these seers regularly predicted a reversion to more modest gains at some point, but they dismissed the prospect of a severe and lasting downturn.

Unfortunately, there is no reliable way to determine how much houses are worth. Many factors come into play, including location, size, condition, interest rates, and the overall state of the economy. In the end, the search for intrinsic value is doomed to failure: all assets are worth what somebody will pay for them. Twenty years ago, gold was worth seven hundred dollars an ounce; now its price is about three hundred dollars an ounce. In January, 2000, stock in Yahoo! was worth nearly five hundred dollars; now it is worth . . . well, no need to go into painful details.

Houses are less volatile than Internet stocks, but their prices vary greatly from time to time and place to place. Taking the United States as a whole, house prices have appreciated by almost forty per cent since 1997, which is the biggest jump in a five-year period since the late nineteen-seventies. Regionally, the pattern has been uneven. In San Francisco, house prices have risen by seventy-five per cent in the past five years; in Boston, they have virtually doubled; on Long Island, they have increased by about eighty per cent. Meanwhile, homeowners in other parts of the country, such as Mississippi, New Mexico, and West Virginia, have largely missed out.

If house prices are considered relative to income—a common method of assessing value—prices in the country as a whole are at their highest levels since the late nineteen-eighties. In San Francisco in 1989, for example, a typical house was selling for a price equal to three and a half times the average family income in the city. During the early nineteen-nineties, the ratio of house prices to income fell, to two and a half. Last year, it moved back above three. In Boston, New York, and Washington, the pattern is similar. Meanwhile, the ratio of house prices to rents has risen to an all-time high. “Valuation looks quite extreme, and not just at the top end,” Ian Morris, the chief United States economist at HSBC Bank, said. “Even normal mom-and-pop homes are now very expensive relative to income.”

Of course, most people who buy or sell a home don’t look at valuation ratios. Potential sellers look at what other homes in the area have fetched; potential buyers work out whether they can afford the monthly payments. Low interest rates and ready access to credit are the main things propelling the market. Last month, the fixed rate on a thirty-year mortgage dropped below six per cent for the first time since 1965.

Richard Dallow ran through the financial arithmetic facing a young couple who buy a home in Levittown for three hundred and forty thousand dollars. Assuming they put five per cent down, their monthly mortgage payments come to about two thousand dollars. Including property taxes and utilities, Dallow estimated the couple’s total monthly housing costs at about three thousand dollars. This may sound like a lot of money for a city cop earning less than fifty thousand dollars a year, but the government subsidizes house buyers with a generous tax break on interest, and in most families there are two wage earners. “When I first started in the business, people could afford a house on one income,” he said. “Today, the husband and the wife both work, and the husband generally works two jobs, just to make ends meet.”

Developments in the financial industry have also made it easier for middle-class families to get big loans. Many real-estate agents now have an in-house mortgage broker who can go online and arrange a loan from any one of dozens of financial institutions. “That is one of the things that has changed drastically,” Dallow said. “We get people approved within a few hours. Some of them don’t even need approval. They come pre-approved.” Twenty years ago, lenders used to set a strict limit of twenty-eight per cent of gross income for mortgage repayments. Today, they rely on software programs, which also take into account the borrower’s credit rating, rental history, and other factors, and some homebuyers end up getting loans with monthly payments that are close to forty per cent of their income. As a result, mortgage-interest payments are consuming a record share of household income.

During the past decade, the Clinton and Bush Administrations have pursued the goal of increased homeownership by encouraging Fannie Mae and Freddie Mac to expand their lending. “Owning something is freedom as far as I’m concerned,” President Bush said recently. “It’s part of a free society.” Thanks to low interest rates and to Fannie and Freddie, sixty-eight out of every hundred American households now own their homes, but worthy policies can have unintended consequences. Cheap money and declining lending standards are often associated with speculative peaks, which invariably are followed by busts.

Whether they realize it or not, homeowners who burden themselves with hefty mortgages are taking a risk, especially if they might need to sell within the next few years. In the housing market, affordability is not the same thing as sustainable value. Current interest rates reflect the depressed state of the economy, and they can’t last. In the next few months, the economy could improve, in which case the mortgage rate would rise considerably. Should it reach 8.5 per cent, which is where it was in the middle of 2000, the monthly payment on a mortgage of three hundred thousand dollars would rise by about five hundred dollars, and many potential buyers in places like Levittown would be priced out of the market. If, on the other hand, a double-dip recession materializes, mortgage rates may drop to 5.5 per cent, but unemployment will increase and many homeowners will be forced to put their homes on the market. At the moment, the jobless rate is only 5.6 per cent, well below its average level over the past thirty years, and most people are either employed or confident of finding work. But if unemployment rises sharply, as it does during most recessions, potential buyers will be too worried about their future to take on a big mortgage, and house prices will fall dramatically.

Realtors like to boast that property is much safer than the stock market, but that isn’t always true. “Ultimately, the weaknesses that infect the stock market almost always catch up with the property market,” HSBC’s Ian Morris warns. After the stock-market crash of October, 1987, house prices rose for three years, but then dropped at the end of 1990. In Tokyo, where the biggest property bubble of the twentieth century took place during the nineteen-eighties, the stock market peaked in December, 1989. Real estate kept going up for another year, whereupon it collapsed.

A homebuyer needs to ask not whether prices are rising currently but how much future buyers will be willing to pay when he or she wants to sell. Many people seem to have forgotten what happened after the property boom of the nineteen-eighties came to an end. Between 1989 and 1995, inflation-adjusted house prices in San Francisco and San Jose fell by almost forty per cent. In Honolulu, the downturn lasted a full decade: between the second quarter of 1991 and the first quarter of 2001, the real price of houses fell by almost a third. These cases are not atypical. In housing markets where speculative bubbles have developed, falls of thirty, forty, or fifty per cent are often needed to restore balance.

When inflation is running at five or ten per cent a year, housing can be made cheaper without prices having to fall much in absolute terms. Sellers keep their asking prices steady, and inflation gradually eats into them. This is what happened during the early nineties in many areas. Today, though, the option of invisible price cuts is no longer available, because inflation has virtually disappeared. (In September, the consumer price index was just 1.5 per cent above its September, 2001, level.) If house prices have to come down in order to restore sanity in the real-estate market, the falls will be out in the open, where everybody can see them.

If the housing market does crack, the ramifications for the rest of the economy are huge. Since the end of 2000, housing has been the biggest source of spending growth in the economy, both directly, through increased homebuilding, and indirectly, through the so-called “wealth effect.” (When a family sees the value of its home rising, it is less apt to save for the future, because it is getting better off anyway.)

As anybody who has tried to hire a carpenter or a builder recently already knows, the country is in the midst of a construction boom. Every month, a hundred and fifty thousand new homes are being built, and in some areas land is getting scarce. The “teardown,” once considered a California curiosity, is now a familiar sight in other places, such as the Hamptons and the North Shore of Long Island. When new homes are built, and when existing homes get more expensive, the country’s stock of wealth increases. In the past seven years, about $2.6 trillion of housing wealth has been created, which translates to about thirty-five thousand dollars for every homeowner. This isn’t nearly as much as the eight trillion dollars of stock-market wealth that has been eviscerated since the Nasdaq crash, but houses are distributed more equitably than stocks, which tend to gather in the portfolios of the already wealthy. Consequently, changes in house prices tend to have a bigger effect on spending patterns than changes in the stock market.

Many families have offset their losses in the stock market by refinancing their mortgages and taking out home-equity loans. During the past two and a half years, homeowners have raised more than three hundred and fifty billion dollars in this way, of which they have already spent more than a hundred billion, on S.U.V.s, furniture, and other consumer goods. In the words of Fortune, “The American home has become a virtual ATM.” Should house prices start to fall, the cash machine would run out of money. Homeowners who bought at or near the top of the market would see the value of their homes fall below the value of their mortgages, a condition known as “negative equity,” and they would try to rebuild their savings. In Japan, Britain, and Scandinavia, this process has in the past led to collapses in consumer spending, and the same thing could easily happen here. Businesses have already severely curtailed their expenditures. Were corporations and consumers to retrench simultaneously, there would be little that Alan Greenspan, or anybody else, could do to prevent a full-blown slump.

Homeowners wouldn’t be the only ones to suffer in a property crash. In the past, the biggest victims were often banks that had extended dubious loans to house buyers and real-estate developers. During the past decade, however, the mortgage industry has changed almost beyond recognition, and banks now play a much smaller role. Today, when Citibank or J. P. Morgan Chase gives one of its customers a mortgage, it is usually acting as a broker. Once a bank has issued a home loan, it bundles it with thousands of others and sells it to investors, a process known as securitization. The investors receive the homebuyer’s monthly payments; and if the homeowner defaults they suffer the consequences.

By far the biggest purchasers of residential mortgages are Fannie Mae and Freddie Mac. The two quasi-governmental enterprises are now among the biggest financial institutions in the country, with almost four trillion dollars in assets between them. Their remarkable growth has helped millions of Americans to purchase their first home, but it has also concentrated a great deal of risk in two enterprises that maintain a smaller capital cushion than regular banks. Fannie and Freddie both buy mortgages on which the borrower has put down as little as three per cent of the purchase price, and they’re giving an increasing number of loans to people with suspect credit histories. Inevitably, concerns have arisen about what would happen to them if the housing market crashed. “They look O.K., but they are big, they are powerful, and they have systemic risk,” Karl Case commented. “And it’s not the kind of risk you can diversify around. You can’t hedge real-estate values.”

Frank Nothaft, Freddie Mac’s chief economist, repudiated concerns about its financial stability. He reminded me that Fannie and Freddie have their own regulator, the Office of Federal Housing Enterprise Oversight, which is about to subject them to quarterly “stress tests,” in which it simulates a sharp rise in interest rates and mortgage delinquencies over a ten-year period, and then checks whether they have enough capital to survive. So far, Fannie and Freddie have passed all the dry-run tests. “For a calamity to happen to Freddie Mac or Fannie Mae, you are talking about some economic scenario that is probably as severe as, if not worse than, the Great Depression,” Nothaft said.

Not everybody is convinced by this argument. William Poole, the president of the Federal Reserve Bank of St. Louis, recently warned that the sheer size of Fannie and Freddie could create a “massive problem in the credit markets.” To pay for all the mortgages they buy, Fannie and Freddie issue bonds, which pay interest to their owners. What would happen, Poole asked, if the market value of these bonds fell sharply, because investors grew concerned about the financial soundness of Fannie and Freddie? “I do not know, and neither does anyone else,” he said. Poole is hardly alone in expressing concern. A couple of months ago, Fannie’s stock price sank after it announced that the recent wave of mortgage refinancings had adversely affected the balance it tries to maintain between its assets and its liabilities. (Fannie has since moved to restore the balance, and its stock price has recovered some of its losses.)

If Fannie or Freddie did get into serious trouble, the repercussions would dwarf the problems at Long-Term Capital Management in 1998, when buyers and sellers withdrew from the credit markets and the financial system almost seized up. That “liquidity crisis” prompted the Fed to organize a multibillion-dollar bailout, which a number of big Wall Street firms paid for. If Fannie and Freddie needed bailing out, taxpayers would probably end up paying for it. The federal government doesn’t guarantee the survival of Fannie or Freddie, but it is unthinkable that it would let either of them fail. When it comes to housing, even the most ardent conservatives in Congress tend to forget their free-market principles.

In Levittown, the prospect of a real-estate crash still seems remote. A few weeks back, I took a tour of some properties for sale with Bruce Golub, a Realtor in the Dallow Agency, who had just come from a closing, at which a house sold for three hundred thousand dollars. Until a couple of years ago, Golub owned a bike shop in town, but a Target opened nearby, and he decided to go into the real-estate business. His first sale was for a hundred and sixty-three thousand dollars. Recently, he sold the same house again, this time for two hundred and seventy thousand dollars.

First, we visited an unmodernized Cape—something of a bargain at two hundred and fifty-nine thousand, but already under contract. Next, we saw a ranch that had been converted into a sprawling five-bedroom, with two separate wings. Its owners, who had moved to Florida, were asking three hundred and forty-nine thousand, and Golub was confident they would get it. Compared with the surrounding towns—Hicksville, Bethpage, Wantagh, East Meadow—Levittown is still relatively cheap. Compared with the North Shore of Long Island, where Golub lives, it is a bargain. “People are literally paying eight hundred thousand or a million for houses and tearing them down,” he told me. “A small ranch sold on my block for eight hundred thousand. I’m driving down the street, I said, ‘Where’s it gone?’ It wasn’t there anymore. They are building a ten-thousand-square-foot home.”

Like millions of Americans, the owners of that monstrosity are betting that bricks and mortar will continue to be the most secure and rewarding of all investments. If they turn the house into a home and live there for several decades, their gamble will probably pay off. But, if they are looking to make some quick and easy money, they may soon discover new meaning in the phrase “safe as houses.” ♦

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